February 13, 2014

Community banks should take note of the headline in The Bond Buyer. October 21, 2013: Banks Accumulate Record Muni Holdings . A detailing of the holdings in Virginia from that same article showed that many community banks in Virginia had noticeably increased their holdings of municipal bonds. This is good news for community banks as well as for Virginias counties, cities and towns.

Tax-Exempt Municipal Bonds

While most of us think of municipal bonds (or munis) as debt obligations issued by the Commonwealth, cities, counties, or towns, in Virginia many munis are issued by public utility authorities, economic development authorities, special tax districts, or other local governmental agencies. Further, local governments issue both long-term and short-term debt. Municipal securities for cashflow short falls and interim financing of capital projects are treated as short-term issues (notes), typically maturing in one year, and, for final financing of capital or equipment, a locality will issue for a longer term (bonds), maturing in more than one year.

Notes are used by an issuer to raise money for a variety of reasons, including: covering irregular cash flows; meeting unanticipated deficits; raising immediate capital for projects until long-term financing can be arranged; and in anticipation of future revenues such as taxes, state or federal aid payments, and future bond issuances.

Bonds are usually sold to finance capital projects, such as the construction of courthouses, offices, schools, or water and sewer systems. The two most common types of municipal bonds are: (1) general obligation bonds, backed by the credit and taxing power of the issuer; and (2) revenue bonds, backed by revenues from a specific project or source. Sometimes tax exempt leases, in combination with a tax exempt bond or note, are used where a designated revenue source is not available.

The typical plan of finance for localities is to offer its bonds to investment and banking houses for sale to investors. This entails the fees and costs of underwriting, trust services, letters of credit, procuring a rating or insurance, and closing costs. Through direct purchase of these securities, banks can offer to reduce or even eliminate these costs. With favorable tax treatment for holding tax exempt debt issued by certain localities, both the bank benefits from a better return and the locality benefits from lower rates. This combination of lower costs and better rates create a business opportunity from which many of Virginias banks benefit.

Local banks understand the infrastructure needs of local issuers and are willing to purchase their bonds. The federal tax code, however, often presents a barrier because typically, if a bank borrows money to purchase tax-exempt debt from a municipal issuer, it cannot deduct the interest it pays to borrow that money. Without a bank-qualified designation, banks have a disincentive to buy tax-exempt debt. The bank-qualified provision permits banks to deduct the interest for these small issues.

Overview

Historically, banks were active investors in tax-exempt bonds. However, the Tax Reform Act of 1986 (the Act) limited the deduction of the carrying cost (the interest expense incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds. For banks, this had the effect of essentially eliminating the tax-exempt benefit of investing in bonds.

Fortunately, there is an exception to the general rule. Banks are still permitted to deduct 80% of the carrying cost of a qualified tax-exempt obligation. [1] This exception treats certain bonds as if they were being issued before the effective date of the Act, which means that the prior tax rule applies. [2]

In order for bonds to be qualified tax-exempt obligations, the bonds must (a) not be private activity bonds (other than qualified 501(c)(3) bonds), (b) be issued by a qualified small issuer, (c) issued for a public purpose, and (d) designated as qualified tax-exempt obligations. A qualified small issuer is an issuer that issues no more than $10 million of tax-exempt bonds during any given calendar year. [3]

As a result, the Act effectively created two classes of municipal bonds: bank qualified (sometimes referred to as BQ) and non-bank qualified. Bonds that meet the above criteria are designated as bank qualified and allow for banks to deduct 80% of the interest costs. Non-bank qualified bonds are those that do not meet the above criteria and, therefore, are not exempt from federal taxes for banks. Because a bank can deduct this carrying cost, bank qualified bonds generally offer a lower interest rate to localities at no cost to the bank.

Keep in mind, that not all municipal bonds are exempt from federal taxes. There is an entirely separate market of municipal issues that are taxable at the federal level, but maintain a tax-exempt status at the state. Furthermore, some tax-exempt bonds are still subject to the alternative minimum tax and are thus not bank-qualified. It is critical to get an opinion of counsel addressing these tax matters.

Direct Purchase

The direct purchase of bank-qualified bonds by commercial banks is attractive to localities — even for smaller bond issues in the $500,000-$2 million range. With this approach, an issuer directly places bonds with a bank. Professional fees, which can make smaller deals uneconomical, are substantially reduced because there is typically no placement agent, remarketing agent, letter of credit bank (and all their additional associated legal fees), rating, and possibly no trustee (or the bank that purchases the bonds will act as trustee and paying agent) as well on these transactions. Bond pricing may be higher, but the offset of the lower fees and costs can have a significant impact on the effective cost of borrowing for smaller deals.

Risks

Because the Code requires localities to document that the bond is a designated issuance and that the locality will not exceed borrowing levels in a given year, the bank should ensure that closing papers provide assurances that they are purchasing a qualified tax-exempt bond. Further, under the Virginia Public Finance Act, the locality must comply with notice and public hearing requirements in order to issue debt. There have been cases when localities have not followed these steps leaving the bank at risk for the bond the bank purchased in good faith.

Conclusion

Despite the slow recovery, Virginias localities still have capital projects necessary to provide critical infrastructure for their operations — schools, emergency services, court facilities, and administration. From replacing emergency service vehicles, to school repairs and renovations, to new facilities to meet the needs of Virginias growing population, community banks are doing their part to support their communities. With reduced taxes to fund these ever-present needs, localities must find cost-effective solutions to fund these capital projects. Community banks can offer competitive rates to localities — especially through the direct purchase of tax exempt, bank-qualified municipal bonds and notes.

Community banks are often the closest financing source for many county, city and town governments. Virginia localities are a solid credit risk. Offering tax advantaged rates for smaller projects with reduced costs is a win-win for both parties, provided that at closing the bank is assured that it can deduct the carrying cost of the loan. Getting an opinion of recognized bond counsel at closing will help with assurances, among many items, as to tax matters, authorization, and enforceability. Getting guidance from bond counsel through the process can also help with due diligence efforts and analyzing credit risk issues.